The Fed's Potentially Very Bad Policy

Incoming data confirms that the economy slid into the heart of the recession in the fourth quarter. The ISM nonmanufacturing report posted a stunning decline in service sector activity. Like its manufacturing cousin, the underlying details were simply depressing, with the drop in the employment component setting the stage for a particularly week labor report later this week.

ADP reported a sharp drop in private employment in November; this report has been underestimating declines in recent months, suggesting the possibility of a blowout number. Auto sales fell off a cliff in November, and I doubt December is looking much better. The Beige Book provided grim anecdotal evidence consistent with the data.

Unfortunately, we will have more months of such data. With the economy already a year into recession, with the worst still ahead, not behind, policymakers will become increasingly desperate to do “something.” And that is exactly when some of the worst policy will evolve.

In the heat of the moment, we love crisis managers. But actions taken by crisis managers, who would argue that something just needs to be done, can yield very bad outcomes over the longer run. As much as I respect incoming administration members Timothy Geithner and Larry Summers, their efforts at crisis management during the Asian Financial Crisis left long lasting effects on the global financial system. During the Asian Financial Crisis, U.S. Treasury officials thought it best to use the IMF as a club to beat struggling economies into submission. As a result, foreign policymakers around the world thought it best to accumulate massive reserves that fundamentally altered the path of capital formation in order to make the IMF irrelevant.

Quietly watching while the U.S. current account deficit expanded validated the global perception of the U.S. as consumer of last resort and further aggravated global imbalances. And if you don’t believe those imbalances are at or near the heart of the current crisis, I urge you to read Brad Setser. Separately, the Federal Reserve in 1998 took on the job of financial market guardian with the LTCM unwind, thereby setting an expectation that the Fed would always prevent anything very bad from happening. But after taking on the responsibility, the Fed never followed through on oversight. Shouldn’t Citi’s (NYSE:C) off-balance sheet entities have raised more questions?

In all honesty, I hold Geithner and Summers less to blame for the aftermath of the Asian Financial Crisis than the Federal Reserve. Arguably, they never had the chance to offset the negative outcomes of their crisis management efforts; the stage was soon taken over by the Bush Administration, which set about eviscerating Treasury. And it is to Geithner’s credit that while at the helm of the New York Federal Reserve he tried to get ahead of the challenges in the CDS market. Overall leadership at the Federal Reserve, however, should have worked to correct the moral hazard they infused into the financial system.

This is not to deny the importance of crisis management, but to point out that when the crisis is over, you need to be able to correct for the excesses of your actions. With that in mind, crisis managers need to be wary of taking actions that they cannot revoke when necessary.

The plan, which is in the development stage, would temporarily use the clout of mortgage giants Fannie Mae and Freddie Mac to encourage banks to lend at rates as low as 4.5%, more than a full point lower than prevailing rates for standard 30-year fixed-rate mortgages.

The key word here is “temporary,” implying a sunset clause. This is a program, however, that screams permanency. Once the federal government defines a right to low rate mortgages, they will find it very hard to reverse their position. (The Treasury may think they can make an arbitrage profit now, but just see what happens when the relative yields flip.) Why? Because at some point in the future, revoking the right will create classes of winners and losers, especially if it results in a steep rise in mortgage rates. And the losers will fight tooth and nail to prevent that rise; just imagine the army of lobbyists from home builders and realtors that will descent on Washington.

(Separately, Calculated Risk questions whether or not the Treasury can meaningfully impact housing prices via the rate mechanism.) Moreover, it seems difficult to imagine that this program can be limited to those buying a home; why should those seeking to refinance be excluded? Wanting to stay in your own home is something the government should discourage?

The Fed has already stepped onto this dangerous ground by announcing plans to bring down mortgage rates by buying agency debt in large quantities. A reversal would threaten their political independence (which perhaps was lost long ago). To be sure, the Fed has always altered interest rates as a tool of monetary policy, and rate increases have always drawn the ire of politicians.

But the Fed could always argue that the impact on home mortgages was simply an indirect consequence of their efforts to stem inflation in the economy as a whole. Now their actions are directly targeted at housing itself; they have announced they have the power to set mortgage rates. Politically, this is very different. At some point in the future, interest rates will need to rise, and I worry at that time the Fed will learn just how hard it is to taken away what Americans view as a God given right – government support for the housing market. Just think about trying to take away the home mortgage deduction.

Perhaps I worry too much. Perhaps it really will be temporary. Consider, however, who is behind this proposal:

The Treasury plan is similar to ideas previously floated by the National Association of Realtors and the lobby group for home builders...

I can only think of Adam Smith’s warning:

The proposal of any new law or regulation which comes from [businessmen], ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

What is the alternative? Stop focusing on the housing market. Stick to policies that will be revocable when necessary. There are virtually unlimited opportunities for good policy in education, infrastructure, and health care, to name a few (Rebecca Wilder fears there may even be too many).

The Fed can support the economy, if necessary, by engaging in quantitative easing with unsterilized purchases of a set number of Treasuries on a weekly basis. This might partially monetize the deficit, but they can demonetize in the future. This maintains their position as supporting the economy as a whole, not a specific interest group. The latter is fraught with political dangers.

Final thought: Neither the Fed or Treasury would be in this position if the latter simply provided agency debt with the full backing of the U.S. government. Then when mortgage rates needed to rise at some point in the future, neither agency would have to take responsibility for the resulting damage to the housing market. Simple versus complicated.